Today's concerns about a volatile stock market trading at historical highs have created an imperative to consider convertibles as a risk-averse alternative to common stocks.
Convertibles provide superior risk-adjusted returns - as measured by the Sharpe ratio - allowing a portfolio manager to obtain equity-like returns with significantly less risk.
Yet convertibles are overlooked by most investment professionals, and therefore are omitted from the asset-allocation process in many cases where they would be well-suited.
One reason convertibles are overlooked is their small-time past. Until about six years ago, the convertible market stood around $50 billion, and most issuers were small to midsized companies. It was difficult for large institutions to make meaningful investments in such a small market.
Big-time present
The domestic convertible market has grown to approximately $115 billion. Including the increasing number of Eurodollar issues by foreign companies, the convertible market is now $190 billion.
About half of the domestic convertible market is investment grade. A new era of high-grade convertible issuers began when IBM Corp. issued a convertible as consideration in the acquisition of ROLM in 1984. Other investment-grade companies that have issued convertibles include AMR Corp., Ford Motor Co., Hilton Hotels Corp., International Paper Co., Motorola Inc. and U S WEST Inc.
The list of Eurodollar issuers also contains investment-grade names, including Ciba-Geigy Ltd., Grand Metropolitan P.L.C. and Roche Holding AG, and such important Asian companies as Bank of Tokyo-Mitsubishi, and Korea Electric Power Corp.
From a risk perspective, it is important to recognize that most convertible bonds are being issued with four- to 10-year maturities. Shorter maturities significantly reduce the downside risk of convertibles.
In the past, convertibles had long maturities that made the bonds' basic investment values highly sensitive to fluctuations in interest rates.
History's biggest test of the convertibles market came in the 1987 crash, when maturities of convertible bonds were 15 to 30 years - much longer than current prevailing maturities. The rising interest rates that preceded the crash sharply reduced the bond value of convertibles; consequently, convertibles failed to provide the expected downside protection. Total return figures from Value Line Convertibles for the fourth quarter of 1987 indicted 585 convertibles lost 20.1%, which barely outperformed the 21.7% loss from the Standard & Poor's 500 Stock Index for the quarter. Given the much shorter maturities of current convertibles, and the higher quality of today's issuing companies, it seems highly unlikely such downside susceptibility of convertibles would recur.
High returns, low risk
The best way of gauging the risk-adjusted performance of convertibles is the Sharpe ratio, which is the standard measure of return received for each unit of risk taken. Convertibles have the highest Sharpe ratio of all traditional asset classes - demonstrating that convertibles maximize returns relative to risk.
The Merrill Lynch Convertible Index confirms the superior risk-adjusted returns.
From its inception in January 1988 through June 1996, the Merrill Lynch Convertible Index had a compound annual return of 13.1%, with standard deviation of 6.8% and a Sharpe Ratio of 1.09. In comparison, the S&P 500 had a compound annual return of 15.7%, standard deviation of 12% and a Sharpe Ratio of 0.85; the Russell 2000 had a 14.8% return, 12.1% standard deviation and 0.76 Sharpe Ratio; and the Merrill Lynch Corporate/Government Bond Index returned 8.9% with a standard deviation of 4.2% and Sharpe Ratio of 0.77. (All data were provided by Merrill Lynch.)
As the figures show, during that period, convertibles returned 83% of the return of the S&P 500 with a standard deviation only 57% as high.
According to a Goldman Sachs & Co. study, between 1973 and 1995 convertibles and the S&P 500 provided virtually identical 12% compound annual returns. The 12.5% standard deviation of convertibles was 72% of the 17.3% standard deviation of the S&P 500, which is good, but not as favorable as the standard deviation of convertible returns for the Merrill Lynch Index. The difference probably is explained by the large number of volatile small-capitalization companies that issued convertibles in earlier years.
With the Association of Investment Management and Research recommending Sharpe ratios be included in presentations by asset managers, consideration of risk and relative return is becoming essential - and convertibles clearly provide superior risk-adjusted returns.
Debunking myths
Myth #1: Why pay a conversion premium if you like a company? Just buy the stock.
Convertibles are priced at issue at a modest premium of 15% to 25% above conversion value. Some managers argue, "I'll buy the common stock and get 100% of the upside, and avoid a conversion premium."
This rationale ignores the interest coupon of the convertible, which in virtually every case exceeds the dividend paid on the common stock. Over time, the premium paid is offset by the coupons received. For example, if a convertible was purchased at a 25% premium over the common stock, with the buyer receiving a 6% yield advantage over the common dividend, and the bond was held for two years and then sold at a 13% premium, then the premium paid would net to zero (25% paid at purchase minus 12% interest received in two years minus 13% received at sale equals zero).
Furthermore, the embedded option in every convertible (the feature that allows a holder to convert) has a value that can be quantified - and might be worth more than the premium paid.
Myth #2: Convertibles are primarily issued by non-diverse, non-investment grade, small-cap companies.
With the expanding universe of approximately 750 domestic and Eurodollar names, convertibles cover a broad cross-section of the market. The breadth of industry diversification for convertible issuers is comparable to the diversity of the S&P 500.
Approximately half of the market is investment grade. More than half of convertible issuers have market capitalizations greater than $2.5 billion, and about 90% have market capitalizations in excess of $500 million.
Myth #3: A balanced portfolio of primarily bonds, with a small common stock component, essentially "creates" a convertible portfolio.
This belief ignores the tendency of convertibles to participate much more in appreciation of underlying stock than in loss.
Because a convertible has a bond value "floor," based on the yield advantage over the common stock, the convertible can hold up relatively well even if the underlying stock declines dramatically.
The conversion premium (the percentage difference between the price of a convertible security and its current value if converted) usually expands if the stock price declines, so the convertible's price declines less than the common price. A "balanced" portfolio would suffer the full negative impact of the declining stock.
If the underlying stock approaches or exceeds the conversion price, however, the convertible trades more like the stock. A balanced portfolio with only a small stock component would therefore underperform convertibles on the upside.
To readjust a balanced portfolio to imitate a convertible portfolio is theoretically possible. But it would require continuous change within the portfolio, no transaction costs, unlimited liquidity and other impossible conditions.
Suitable for many buyers
Aside from superior risk-adjusted returns, convertibles have additional benefits for certain institutions.
Insurance companies benefit from favorable regulatory treatment of convertibles. Standards of the National Association of Insurance Commissioners require insurance companies to reserve against investments. Equities must be reserved at up to a 30% rate.
Convertibles, however, are reserved identically to straight debt: 2% or less for investment-grade (NAIC-rating 1 or 2) bonds, and 5% for BB rated (NAIC rating 3). Most convertible bonds are rated BB or higher.
Insurance companies therefore can maximize investment returns, while minimizing required capital, by using convertibles. Convertible bonds can be carried at cost by life insurers (for NAIC 1 through 5 bonds). Convertible preferreds are tax-advantaged: 70% of dividends received are excluded from taxation.
Endowments can obtain the high current income that most require - while enjoying equity-like returns - by investing in convertibles.
Undervalued niche market
Despite the growth and diversification of the convertible market, it remains a niche that has attracted limited expertise.
As an example, hundreds of investment letters are dedicated to common stocks, while only Value Line Convertibles is dedicated to convertibles. Notably, the sole convertible letter is ranked first for risk-adjusted return, according to the Hulbert Financial Digest. At most brokerage houses, just one or two analysts are dedicated to convertibles, vs. hundreds of equity and fixed-income analysts.
The convertibles market provides many overlooked investment opportunities of the sort no longer available in more efficient markets.
The next 12 months
Convertibles are poised to continue to do well in the next 12 months.
The average convertible yields 6.7%, or 450 basis points more than the 2.2% yield of the S&P 500. This yield advantage greatly enhances the total return from convertibles, and increases the odds convertibles will provide returns comparable to the returns from stocks, but at measurably lower risk.
Convertibles can perform well under various market conditions:
Falling markets. The 6.7% yield of convertibles provides a downside "floor" that will support the price at the same time it provides a significant yield advantage.
Flat markets. Convertibles automatically would outperform by the yield advantage of 450 basis points, barring a fluctuation in the market rates of interest that both reduced the investment value of convertibles and did not reduce stock prices.
Rising markets. Convertibles probably would provide competitive returns at significantly less risk. Active managers of convertibles seek 75% of the upside return from stocks. Consider that, since 1950, the S&P has provided a compounded return of about 12% annually. In order to obtain a 12% return in the context of the current 2.2% yield, the 500 stocks would have to appreciate 9.8%. In contrast, convertibles that yield 6.7% would have to gain only 5.3% to return 12% - a modest price increase for an equity-linked security.
Convertible securities provide a practical means of participating in a volatile stock market - which has provided the highest returns historically - while minimizing risk and capitalizing on the yield advantage.
The asset allocation process should be broadened to include convertibles when evaluating potential investment vehicles.
